Major miner

RS fund manager Davis is Stockpicker of the Quarter

SAN FRANCISCO (MarketWatch) -- Shares of natural-resources companies have energized world markets, but knowing what to buy and when requires greater insight than just choosing a stock and waiting for a gusher.

The three commodity-related stocks that Davis recommended in mid-November hit pay dirt, rising an average of 24.6% in the 13 weeks after he named them. That earned him the MarketWatch Stockpicker of the Quarter distinction.

In winning, Davis bested several dozen rival mutual fund managers profiled in MarketWatch's column "The Stockpickers" during the fourth quarter of 2004.

Davis' choices reflect both the natural resources sector's powerful surge and his own requirement that managers of these cyclical companies treat their windfall profits responsibly.

Peabody Energy Corp.
BTU, -2.12%
steamed ahead as the top performer. Shares of the nation's largest coal producer added 34.1% from the opening bell on Nov. 12, when an interview with Davis appeared on MarketWatch, through the market close on Feb. 11. See full story.

The two other stocks Davis mentioned also rose sharply. Shares of Australian mining giant BHP Billiton Ltd.
BHP, -2.44%
gained 19.9% in the period. Meanwhile, shares of Canadian steelmaker Algoma Steel, Inc. (AGA) soared 19.8% in the four weeks following Davis's recommendation. He sold the position then, but the stock continued to appreciate over the following weeks.

"We're willing to forgo some upside to be stricter on valuation," said Davis, who joined the fund as an analyst in March 2004 and became co-manager in January. "Our sell discipline and valuation discipline is built around deriving a warranted value, and exiting once shares hit that point as long as there's been no improvement in the fundamentals."

Davis topped 35 other investment professionals featured in The Stockpickers during the fourth quarter of 2004. In these stories, professional investors recommend three stocks, which are then tracked over the following 13 weeks -- the last period of which began on Dec. 30 and ended on March 31.

Chosen stocks can be domestic or international, covering all market sizes, investment styles and industry sectors. Each stockpicker is measured on how the selections fare from the closing price on the day before the story is published to the nearest trading day 13 weeks later.

The results from Davis's stocks beat runner-up Chris Wiles of the Armada Large Cap Core Equity fund
ACQAX
whose three large-company stocks -- also mentioned in mid-November -- rose 21.2% on average over a 13-week period.

Natural-resources sector funds have been standout gainers for more than a year. The category's 29.4% average rise over the past 12 months through April 26 tops all other U.S. rivals, according to research firm Morningstar.

This tailwind worked to Davis's advantage. Global Natural Resources rose 10.3% in the 13 week period, though still behind the 11.4% gain for the average natural-resources fund.

Other stock pickers interviewed may not have had the same advantage when choosing stocks because their own investment styles were out of favor at the time they made their selections.

Drilling down

Many oil, energy and commodity companies are benefiting from scant supply and surging demand. Peabody Energy has a different kind of driver. The company is mining enough coal to satisfy demand, Davis said, but there's a lack of available transportation to deliver it to users.

Davis recommended Peabody in mid-November at a split-adjusted price of $32.96 a share; the stock rose 34.1% to $44.20 over the next 13 weeks. The fund began building a position in December 2001 at an average cost of $17.62 a share.

"The valuation remains compelling," Davis said of Peabody stock. "Over the long term, what drives stock performance is real after-tax cash returns on invested capital. [Peabody] continues to do a terrific job deploying capital. They are opening up new mines with locked-in contracts."

Algoma Steel is gone from the portfolio, sold in mid-December after Davis decided that the share price had run ahead of the metal's long-term prospects.

By then, just a few weeks after the Stockpicker interview appeared, the stock had soared 19.8% to $29 a share from $24.20. With an average per-share cost of $6.84, the fund managers concluded it was time to take profits.

Davis said he has no regrets about selling Algoma. He and Pilara simply weren't able to determine a key requirement of their investment strategy -- namely how companies use cash to create shareholder value.

"We look at a company's cash flow and its ability to redeploy that cash into projects that will continue to earn above the cost of capital," Davis said. With Algoma, he noted, "It wasn't clear where that capital was going to go. We also had broader concerns about the steel market."

No such dilemma faces Davis about BHP Billiton. The Australian mining group has broad interests in metallurgical coal, iron ore, copper and nickel. "We derive a certain comfort from the diversity of their portfolio assets," Davis said of BHP.

While Davis is concerned about commodity prices over the short term, he said the multiyear outlook for producers such as BHP -- and the natural-resources sector -- is compelling.

"You've got a lack of investment on the supply side, which is constraining production," he said, "and you've got reasonable demand growth over the next five years" from industrialized and developing nations.

The fund started buying BHP stock in March 2004 at an average cost of $21.82 a share. The stock traded at $22 when Davis recommended it in mid-November and rose 19.9% over the next 13 weeks to $26.38 a share.

At the pump

Davis and Pilara divide their $981 million no-load portfolio among 53 natural-resources firms that meet their strict investment and valuation criteria. For these managers, after-tax cash flow is king. They want to know that company executives are realistic not just about making money, but spending it.

"Were looking for managers who are intelligent and sophisticated allocators of capital," Davis said.

If that bar isn't high enough, Davis and Pilara raise it. Before they buy, a firm's stock must be trading at least 50% below their estimate of what the company will be worth in two or three years.

Global Natural Resources has posted substantial returns for shareholders since its 1995 inception. Its 31.3% gain over the 12 months through April 27 tops the 27% rise for the average natural- resources fund, according to fund-research firm Lipper. A $10,000 investment in the fund when Pilara started it in November 1995 would be worth about $30,000 today.

Patching into oil

Other Global Natural Resources holdings that dig deep include Western Oil Sands Inc. (WTO), a Canadian mining group that owns 20% of an ambitious effort to squeeze oil out of layers of northeastern Alberta sand.

The Athabasca Oil Sands Project is among the world's largest crude-oil sources, and Western Oil Sands brings management and mining expertise to this joint venture with Shell Canada, a division of Royal Dutch Petroleum Co.
RD
and ChevronTexaco Corp.'s
CVX, -0.35%
Canadian unit.

Davis said Western Oil Sands' management is realistic about its task and future crude prices.

"They have a credible plan to upgrade capacity," he said. "And at their long-term oil-price predictions -- north of $30 a barrel and south of $40 -- they can generate healthy returns."

The fund began adding shares of Western Oil Sands last July at an average per-share cost of $29.96. Now a 3.6% fund position, the stock closed Thursday at $55.50, down $1.70.

Davis also recommends Patterson-UTI Energy
PTEN, -1.74%
a contract land driller for the oil-services industry.

Oil producers are drilling new wells in a bid to extract more crude supply, Davis observed, requiring additional equipment and drilling rigs and allowing companies like Patterson to charge higher prices for their work.

Davis started buying Patterson shares in September at an average per-share cost of $18.44. On Thursday, shares of Patterson-UTI Energy, a 2.7% fund holding, closed at $23.75, off 88 cents.

"The company has done a good job of redeploying cash," he said. "They stand out as being cheap on an absolute basis and being fundamentally well-positioned."

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